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One uncertainty facing the stock market concerns artificial intelligence (AI) and whether it is just another in a long line of bubbles.
AI is something that could change the world, and yet we don’t really understand how it will work as an industry yet. This combo provides absolutely perfect bubble fuel – it allows Wall Street to make all sorts of amazing claims.
And sooner or later, the hype will end and AI stocks will cool as reality sets in.
That makes now a good time to look for a technology stock that is a defensive AI play. One such company is KLA Corporation (KLAC).
Getting to Know KLAC
There are three main semiconductor equipment makers in the U.S., namely Applied Materials (AMAT), Lam Research (LRCX), and KLA Corporation. KLA can be distinguished from the others in that it prioritizes process control and yield management tools. It provides testing and inspection products that ensure chip manufacturers can run at full speed. Process control makes up about 90% of the company’s revenues and gross profits. KLA's process control market share exceeds 55%, four-times as high as its closest rival.
Not surprisingly, this has made KLA a highly profitable business. Returns on invested capital are above 30%, while its sector-leading operating margin sits at close to 40%. And KLA is benefiting from artificial intelligence. The company’s wafer inspection business is growing rapidly thanks to the ongoing boom in AI, with sales up 36% year-over-year in the third quarter.
Looking ahead, KLA has other growth opportunities in areas such as “advanced packaging.” According to researchers, the chipmaking industry is working quickly to navigate limits of miniaturizing. The Financial Times found that:
“… Chipmakers are being forced to identify alternative means to keep improving performance. By integrating or ‘packaging’ multiple chips – whether of the same kind or different varieties – more closely together, chipmakers can increase speed and efficiency while circumventing the limits of miniaturization. The world’s leading chipmakers are pouring billions of dollars into expanding and improving advanced packaging techniques, which is good news for KLA. This greater complexity in advanced packaging will translate to a greater need for the testing that the company provides."
That’s why KLA believes it is positioned to outperform its peers in coming years, given that inspection tools have historically outperformed wafer fabrication tools in down years for the overall industry.
The China Effect
Of course, it’s not all a bed of roses for KLA. For instance, the company is facing competitive pressures from companies in China and Japan. The company currently expects China’s share of its total sales to fall from 42% this year to around 30% next year, as U.S. restrictions placed on the sale of semiconductor technology really kick in.
However, the slack will be taken up by its growing business in the U.S. North America sales doubled in the third quarter, as businesses rushed to build domestic semiconductor capacity, and now make up 18% of total sales.
And of course, there is Taiwan Semiconductor Manufacturing (TSM). It accounted for over 10% of KLA's total revenue in the fiscal year 2024. TSM, also a beneficiary of AI demand, is projecting ongoing revenue growth.
That’s probably a major reason why, during its earnings call, KLA CEO Rick Wallace said, “While some customers are facing near-term challenges, we are optimistic about continued semiconductor market growth in the fourth calendar quarter of 2024 and into calendar 2025.”
The Bottom Line: Buy KLAC Stock
High switching costs give the company a good competitive moat. Once inside a customer’s business, the complexity of KLA’s equipment and its embedded services make it “sticky.”
In addition, KLA has a good track record at growing its business through different market conditions. It also has a tendency of beating analyst estimates come earnings time.
Nevertheless, if the semiconductor industry catches a cold, KLA feels it too. KLA's shares are now about 27% below their July highs.
Analysts at Citi think the semiconductor cycle is in “Phase 3,” which calls for defensiveness. Building on that, Citi says KLA remains “the best place to hide” in the equipment sector. The analysts think KLA’s guidance has de-risked the China issue more effectively than Lam or Applied Materials. Citi also cites the company’s focus on AI-related “leading edge” chips.
I agree with their assessment. Over the longer term, KLA stands to benefit from the CHIPS and Science Act and other initiatives that recognize semiconductor production as a national strategic priority and a component of national security.
Integrated semiconductor companies building new fabs in the U.S. turn to KLA for advanced metrology solutions, a niche where the company is building on its role as the market leader.Metrology tools will also be indispensable as demand surges to meet voracious semiconductor needs in large language models, training, inference, and other generative AI tasks.
Add it all up and KLAC is a buy below $675. It would not surprise me to see it trading back up to its previous peak at $896 within six months.
